In Baker's Take, J. Pat Powers and Kendall L. Houghton with Baker & McKenzie State Tax Practice write about the effects on various businesses of California's shift to market-based sourcing.
California is the latest state to join the trend in changing the rules on taxation of income from services or intangibles, and those changes will have major effects on the tax liabilities of companies earning those types of income. This article reviews the recent law change in California and highlights some ramifications of the new regime for in-state and out-of-state taxpayers.
Modifying state tax apportionment formulas to emphasize a market-focused approach has been a major trend in state taxation during the last decade. This trend manifests itself in two different but related ways. First, many states have moved from the traditional three-factor apportionment formula that gave equal weight to the taxpayer's property, payroll, and sales (also referred to as gross receipts) as revenue generators. The Uniform Division of Income for Tax Purposes Act was adopted in 1957 by the National Conference of Commissioners on Uniform State Laws and was approved that same year by the American Bar Association. UDITPA followed the equally weighted three-factor approach. Most states adopted UDITPA, and the equally weighted three-factor formula became the prevalent method for apportioning business income for many years. Indeed, the U.S. Supreme Court recognized it as the "benchmark against which other apportionment formulas are judged."1
Many states became concerned that the traditional three-factor formula was not in harmony with their economic development objectives, and accordingly several states increased the weight given to the sales factor (for example, double-weighting the sales factor), or even made the taxpayer's sales/gross receipts the exclusive factor for apportioning business income. The theory behind those changes was that policymakers did not want to discourage investment and creation of jobs in their state, so more of the tax burden should be shifted to out-of-state companies that used the state as a market rather than as a location for production and jobs. Increasing the weight of the sales factor arguably facilitated those economic development objectives for taxpayers that manufacture and sell tangible products, but this change by itself did not create the desired incentives for service businesses or businesses that derived significant income from intangibles. The reason for this disconnect is that the traditional UDITPA formula sources most receipts (other than from the sale of tangible personal property) to a single location, that is, where the taxpayer incurred more of its costs of performance (COP) in producing the income than in any other state. This location is frequently, but not always (especially when activities are performed on behalf of the taxpayer, or when employees travel to perform services), a state in which the service provider has located property and employees.
Accordingly, the results of that COP-based sourcing of services and intangibles receipts stimulated the second major change in how states apportion such income for taxation. To achieve their objective of exporting the tax burden, many states concluded that they needed to change the sales factor sourcing rules as well as the weighting rules, and several of them have already done so. For example, Georgia, Illinois, Iowa, Maine, Maryland, Michigan, Minnesota, Ohio, Utah, and Wisconsin have all adopted market-based sourcing regimes for services and intangibles receipts.
California Adoption of Market-Based Sourcing
California will join that list of states when it adopts a market-based sourcing approach for receipts from services and intangibles, effective for tax years beginning after January 1, 2011. Taxpayers with significant income apportioned to California should start preparing now.
In 2009 California made drastic changes to its corporate income tax. Most taxpayers (other than taxpayers in extractive industries or farming, or banks and financial institutions) will have a choice to apportion income based on the current three-factor double-weighted sales formula or a single-sales-factor formula. The election must be made in a timely filed original return, but elections are not binding for future years and taxpayers can make a different election each year. (If passed by the voters, an initiative measure that appears likely to qualify for the November ballot would eliminate the election for single sales factor.)
Regardless of the apportionment formula chosen, receipts from services and intangible property will be sourced based on where the benefit of the service is received or where the intangible property is used. Both of those concepts are novel in California tax law, and in drafting regulations, the Franchise Tax Board is seeking public input.
States that have adopted market-based sourcing have taken various approaches in trying to define the market, but each of these approaches represents a comparatively recent development. Consequently, the law is not yet well developed in specifying what the "market" is for purposes of a given market-based sourcing rule. Statutes in several states focus on where the services are received2 and where the intangible property is used. Statutes in other states source receipts according to where the recipient of the services receives the benefit of the service.3 It is not clear whether these are substantively different tests, or if they are essentially the same test expressed in slightly different terms.
For example, in Georgia, if net business income is derived principally from business other than the manufacture, production, or sale of tangible personal property, gross receipts are considered Georgia-sourced if they are derived from customers within Georgia or if the receipts are otherwise attributable to Georgia's marketplace.4 Presumably, Georgia will allow proration of those receipts for sourcing purposes if a customer is within Georgia but also has locations in 40 other states to which the services were delivered, or where the benefit of such services was received, or in which the customer uses some portion of the services. Although the regulation repeats the statutory provision, it also specifies that the gross receipts factor is designed to measure the marketplace for taxpayers' goods and services.5
Identifying what the market is -- or more specifically, using the terminology in the California statute, where "the purchaser received the benefit of the services" or where the intangible "property is used" -- can create uncertainties and difficulties for California taxpayers. For example, if a software company licenses design software to a large manufacturer with design centers in 5 states and 3 foreign countries, manufacturing facilities in 11 states and 9 foreign countries, and sales offices everywhere, the question of where the software is used arises. Related questions include:
- to what extent is it used where;
- does the licensor software company have to know where and how its customer uses its software; and
- if so, how does it find out?
At a preliminary Franchise Tax Board hearing to seek public input on the regulations, various possibilities were suggested by the FTB and participants, including several rules of convenience such as: use of the billing or ship-to address (if there is one, rather than simply electronic delivery), or use of the customer's legal or commercial domicile. Meeting participants acknowledged the difficulty in knowing enough about the nature and location of a customer's use to effectuate a proration of receipts received from a single customer.
Further, participants expressed support for simple rules that are easy to apply (for example, using information from the taxpayer's accounting records, such as customer billing address). This is not the first time such questions have been raised concerning the potential problems facing taxpayers that must apply the purportedly straightforward market-sourcing regime. For example, in 2007 Illinois replaced its COP sourcing regime with a market-based sourcing rule. In its first take on market-based sourcing, Illinois adopted a rule similar to California's and provided that service revenue should be sourced to the location where the benefit of the service was realized. Taxpayers expressed concern regarding what information they had to collect to determine where their customers realized benefit from the services provided. To respond to those concerns and simplify the compliance burden, the legislature adopted a new sourcing rule that was deemed easier to administer: Services receipts are sourced to Illinois if services are received in Illinois.
In the FTB's hearing, representatives from some larger companies suggested that although the adoption of simplified market-sourcing rules might over- or understate the role of the California market in a particular transaction, overall the overstatements and understatements would tend to cancel each other out. Nevertheless, a taxpayer whose return reflects a net overstatement of the California marketplace's role in its production of income might view the new market-sourcing apportionment rule as distortive under section 25137 of the California Revenue and Taxation Code (that is, the state's equivalent to UDITPA section 18, alternative apportionment relief). The FTB will schedule additional hearings, and affected taxpayers should express their views on the appropriate approach.
Reduced Importance of Classification of Type of Transaction
Several collateral consequences will result from California's adoption of a market-based sourcing approach. Classification of a transaction as the sale of tangible personal property or something else will become less important. A 2002 dispute illustrates this point. In Appeal of PacifiCorp., 2002-SBE-005, the taxpayer generated and supplied electricity, and the issue was whether electricity constituted tangible personal property for apportionment purposes. That classification question was crucial. If electricity was deemed to be tangible personal property, it would be included in the California numerator of the sales factor because receipts from the sale of tangible goods are sourced by reference to their destination. However, if the receipts were from something other than the sale of tangible personal property -- for example, services income -- the receipts would go in the sales factor denominator but not the California numerator because the taxpayer's costs of producing the electricity were not incurred in California. The Board of Equalization classified the receipts as being from the sale of something other than tangible personal property, and thus PacifiCorp was not taxable in California on those receipts under the COP sourcing rule then in place. Had California been following the new market-sourcing approach, that preliminary classification question as to what type of income was involved probably would not have mattered, and the receipts would have been in the California numerator.
Inconsistency With Other States
Adoption of market sourcing will presumably shift the tax burden away from taxpayers with a disproportionate amount of property and payroll in California. When that is combined with an election to go to a single sales factor, some California-based taxpayers should experience drastic reductions in their California tax liability. Conversely, taxpayers that did little in the way of production in California but earned significant revenue from California customers are likely to see their California tax liabilities increase. Depending on the apportionment and sourcing rules in effect where such taxpayers undertake their services or develop their intangibles, some taxpayers will find states taxing more than 100 percent of their income. Of course, the switch to market sourcing will not affect receipts from traditional manufacturing and mercantile operations involving tangible personal property, which were already sourced on a destination or market basis.
Also, depending on what rules ultimately are adopted for determining the market, some taxpayers may have opportunities to structure their activities to reduce California tax. Taxpayers with significant California payroll and property may be able to significantly reduce California tax liabilities without a corresponding increase in their tax burden in other states. In that instance, California-centric taxpayers may benefit from the inconsistencies in the rules among the various states.
Financial Statement Impact
An interesting but perhaps largely unforeseen collateral consequence of the switch to market sourcing is that some taxpayers with large California tax attributes (such as credit carryforwards) may be unable to fully use the attributes. Consequently, some companies may have to take a valuation allowance against their tax attributes, and that change will affect reported earnings for financial reporting purposes.
The FTB process of adopting rules and preparing regulations to implement market-based sourcing is just getting under way. As demonstrated by the recent experience in Illinois, taxpayers with significant California tax liability should analyze the effect of market-based sourcing on their situation and participate directly or through representatives in this process to avoid the adoption of rules that adversely affect them. California administrators have indicated that the door is open to taxpayer presentations and advocacy regarding the most appropriate benchmarks for market sourcing of services and intangibles receipts.
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J. Pat Powers is a partner in the Palo Alto office of Baker & McKenzie whose practice focuses on both federal and state and local tax planning and controversy. Kendall Houghton is a partner in the Washington, D.C., office of Baker, where her practice encompasses state and local tax planning, policy, and controversy, as well as unclaimed property legal issues.
This bimonthly column by Baker & McKenzie LLP's State Tax Practice members will focus on current developments, trends, and practice issues confronting the Baker attorneys that present opportunities, pitfalls, and decision points for state tax professionals. Articles will present the Baker authors' take, and take-aways, regarding the subject under review.
1 Container Corp. of America v. Franchise Tax Board, 463 U.S. 159, 170 (1983).
2 See, e.g., Maine Rev. Stat. Ann section 5211(16-A).
3 See, e.g., Mich. Comp. Laws Ann. section 1305(2)(1).
4 Ga. Code Ann. section 48-7-31(d)(2).
5 Ga. Corp. R. & Regs. 560-7-7-63(5)(c)(1).
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